Saturday, January 11, 2014

Krugman claimed that 2013 would be a test of Market Monetarism. Market Monetarists rejected that claim, because the Fed didn't target the level of nominal GDP. The Fed didn't give up on interest rate targeting. The Fed continued to pay interest on reserves. It is also true that the Fed didn't start trading index futures contracts on nominal GDP. (Even I count that last one as asking a lot.)

Kling has accused Sumner of making Market Monetarism irrefutable. Kling said that suppose the Fed said that it was targeting the level of nominal GDP, but the business cycle continued as before. Market Monetarists would either accept that targeting the level of nominal GDP did no good, or they would say that the Fed was not really targeting the level of nominal GDP. He said that he anticipated that we would do the second thing.

I think this is due to Sumner's claim that nominal GDP expectations are the stance of monetary policy. Sumner argues that actual nominal GDP varies little from expected future nominal GDP, and so that when nominal GDP changes, especially if the change is significant, it was due to changes in expected future nominal GDP. And that means it changed due to a change in the Fed's monetary policy stance.

How could this be refuted? I think Kling has in mind a situation where actual nominal GDP deviates from the target, and fluctuates as before. If shifts in nominal GDP are defined to be loose or tight monetary policy, then nominal GDP level targeting hasn't failed. The Fed has failed to implement the proper monetary policy by definition.

But that isn't all there is to Market Monetarism.

In my view, the most obvious test would be a situation where nominal GDP does remain close to the target growth path, but the business cycle, understood to be fluctuations in real output and employment, continues as before. Obviously, inflation would be strongly countercyclical.

Now, Market Monetarists believe that booms and busts would continue to exist even with perfectly successful nominal GDP level targeting due to supply-side factors. So, the test would be whether there really are any "demand-side" business cycles. Or, whether an alternative regime, like inflation targeting exacerbates supply-side recessions. I think the test would need to compare the fluctuations of real output and employment under a period of nominal GDP level targeting to some other monetary regime.

Of course, it might be possible to actually identify supply side factors directly. Are the business cycles under nominal GDP level targeting more closely related to various supply side factors?

Now it would be really interesting to see how nominal GDP level targeting performs with a financial crisis. If nominal GDP remained on target, but real output fell and inflation rose, presumably because of the inability of the financial sector to efficiently allocate credit, then that would count against nominal GDP level targeting.

But Kling isn't worried about that sort of test. It is rather the central bank adopts nominal GDP level target but fails to hit the target.

One possibility is that nominal GDP fluctuates exactly as before, but around the target. That would be the most challenging scenario. How hard are they trying keep nominal GDP on target? Of course, if they say, we can't do it because short term interest rates would change too much, or the quantity of base money would change too much, then we would say they aren't really trying. They are targeting the level of nominal GDP subject to the constraint that something else, such as money market interest rates, remain within reasonable bounds.

On the other hand, if nominal GDP was below target despite interest rates on reserves being negative, a significant currency drain, and the Fed owning every asset it can legally own, then that would count against Market Monetarism. Sure, we could say that they could still do more, but Market Monetarists generally argue that with a nominal GDP level target, they should be able to raise nominal GDP.

On the other side, if nominal GDP was above target even after the central bank has sold off all of its assets, then maybe they are doing the best they can.

Of course, if nominal GDP is fluctuating around the target, it is possible that the changes in base money are excessive and causing overshooting.

But what about a different scenario. Suppose nominal GDP shifts to a new trend, and the Fed is committed to return to the target growth path, but nothing it does shifts nominal GDP. If the problem is not excessive fluctuations around the target, but rather stabilizing below target, then the test of whether they have bought all the assets they can or sold off all of their assets would be telling.

If they were really trying and nominal GDP would not move to target, that would count against Market Monetarism.

Interestingly, Market Monetarists argue that a nominal GDP level target would generally require more modest changes in base money or interest rates than inflation targeting. This is because of automatic stabilizing features of the regime. This could be tested by looking at the variation of base money or interest rates controlled for deviations of the goal for target.

Finally, there is the test of whether the market expectation of future nominal GDP strongly impacts current nominal GDP. If the expectation of future nominal GDP can be measured, and it stays on target, but nominal GDP fluctuates as before, then this would be a test of that view.

However, the better test would be if nominal GDP were expected to deviate from target, and it really stayed the same.

Suppose nominal GDP level targeting is implemented, and the market shorts nominal GDP contracts. The Fed takes the opposite long position. Nominal GDP remains on target. This would count against Sumner (and my) view that index futures convertibility is desirable.

One of Summers' arguments for fiscal policy is that the low interest rates generated by monetary policy results in excessively high asset prices.

While it is true that given the expected return on an asset, a lower interest rate raises the asset's present value, the problem is supposed to be "secular stagnation." There is an excessively high supply of saving and excessively low demand for investment.

But the low demand for investment is being generated by low expected returns on real investment. Given the interest rate, that results in a lower present value of an asset. And to the degree that excessive saving is driving down the marginal return on investment, the result is the same.

And so, secular stagnation should lower asset prices at a given interest rate. The lower interest rate, then, simply dampens the decrease in asset prices.

To the degree there is a decrease in the quantity of saving supplied and increase in consumption due to the lower interest rates, the fundamental value of the assets falls.

If the supply of saving were perfectly inelastic with respect to the interest rate, then the interest rate must fall enough so that despite the lower expected return on investment, asset prices remain the same, and so it remains profitable to maintain real investment expenditure.

Now, it is also true that if there are fewer low risk, high yield projects available, the rational approach to investment is not simply to exploit equally low risk, lower yield projects. It is also sensible to exploit higher risk, equally high yield projects as well. There is nothing wrong with "a reach for yield." It is perfectly rational.

Of course, it would probably be more sensible for households to purchase equity to avoid lower yields rather than keep their money in banks that claim to promise the same safety without a reducing yield. In other words, to the degree a bank wants to promise depositors the same safety, it should lower the interest rate it pays enough to make it possible to fund a lower yield, equally safe asset portfolio. Those depositors who want a higher yield should buy stocks.

But if depositors want to earn a higher return and take a higher risk on deposits, should it be forbidden? I don't think so. But I don't think they should have government deposit insurance or even a lender of last resort.

What should be done instead? Option clauses and rapid resolution of insolvent institutions.

And most importantly, nominal GDP level targeting so that financial problems don't cause persistent shifts in the growth path of spending on output.

Finally, if the central bank is using a policy interest rate to target inflation, and the growth path of spending falls, and the lower spending results in depressed real output, and it is that depressed real output that reduces expected future returns and so equity prices, then if the central bank shows a willingness to shift to a more sensible policy, stock prices will rise because of the higher expected returns.

Now, suppose that to keep stock prices from rising, a foolish monetary policy is maintained. Instead, the national debt is increased enough so that national saving is low enough, that the interest rate that keeps saving and private investment equal prevents any increase in expected returns so that stock prices remain depressed. Further aiding this policy is the possibility that business profits will be taxed in the future to pay the interest on the national debt. By reducing expected future after tax profits, that will also keep stock prices depressed.

Nick Rowe argued that the zero nominal bound is an illusion and that the real issue is the desired size of the central bank's balance sheet.

I agree that the zero nominal bound is largely self-inflicted by central banks, but I don't agree with Rowe's argument. He argues that there is a spectrum of assets that are more or less liquid. The more liquid, the lower the yield. This creates a continuum of assets with progressively higher nominal yields. Rowe's point is that there is always some asset that is close to the zero bound. An expansionary monetary policy generates a perfectly liquid asset by purchasing a somewhat less liquid asset. If the central bank buys up the most liquid nonmonetary assets first, and then goes to progressively less liquid ones, then it will always be pressing against a zero nominal bound. The only question is how far it must go to keep inflation (or the level of nominal GDP) on target.

I think there is an element of truth in this argument, but I am pretty sure that with competitive issuers, a highly liquid asset can have a substantially higher nominal yield than currency. Checkable deposits are extremely liquid, but their yield depends on the return that banks can earn on their asset portfolios and the cost of providing intermediation services.

But this high yield creates an incentive to deposit currency. Doesn't that result in banks lending more, driving down the returns on their portfolios, and so the yield on deposits? Not if there a nominal anchor, like a growth path for nominal GDP. The quantity of currency is reduced to match the lower demand for it. The implicit yield on the services provided by currency rises to match the yield on deposits.

Now, suppose rather than conventional banking, the only option is to either hold currency or else competitively-issued bonds. The issuers fund real investment projects. There are costs to underwriting the bonds. Further, there are transactions costs to managing "cash." But does the nominal yield on these bonds have to approach zero? That is, will people buy the bonds, driving down their yields, and I suppose fund more real investment projects until those yields are driven down? No. With a nominal anchor, the quantity of currency is reduced to meet the demand.

As Rowe surely knows, the whole point of Friedman's optimum quantity of money is to generate a deflation rate so that these competitive nominal interest rates are driven to zero, raising the demand for currency. The implicit nominal yield is driven to zero. And, of course, the high real demand for currency in this situation implies a larger real balance sheet for the central bank.

Still, I agree with Rowe that the zero nominal bound is largely self imposed. Suppose the central bank issues currency. However, it is prohibited from buying government bonds. It solely buys corporate bonds. The corporate bond market it entirely made up of 10 year notes. The corporations fund risky investment projects, but they are mostly diversifiable. The central bank's asset portfolio isn't very risky. Even so, if the central bank were to become insolvent, the government promises to bail it out. The interest rate on these corporate bonds is 8 percent. The quantity of currency is $6,000 billion, and nominal GDP is $15,000 billion.

There is a national debt. It is very small, only $1 billion. It is funded entirely by T-bills. The government runs a slight budget surplus, so the outstanding national debt is generally decreasing. The T-bills are very liquid. Some people manage their cash positions using the T-bills. The yields are only 2 percent and have been dropping over time.

The central bank has noticed that when it expands the quantity of money by purchasing corporate bonds, the yield on T-bills falls. And further, when people are short on money, they reduce expenditures on a variety of things. Those who have fewer receipts are also short on cash, so they reduce expenditures. However, those who hold T-bills to manage their cash balances sell them when they are short on money, raising the yield.

The central bank decides to target the T-bill rate. It is pretty effective. New Keynesian economists develop complicated models where consumption depends solely on the T-bill rate. They even have models explaining the relationship between the yield on T-bills and the yield on corporate bonds. The corporate bond rate is equal to the expected future T-bill rate plus a risk premium.

Now, suppose the government pays off the entire national debt. There are no more T-bills. There is no yield on T-bills. Does monetary policy become ineffective? If the only short and safe asset is currency, does monetary policy become impossible?

Well, the demand for currency will rise because T-bills can no longer serve as money substitutes, but given the numbers I described, this is just a drop in the bucket. Those who were managing their cash positions no longer earn a return. Like everyone else, they just use zero nominal interest currency.

Clearly, all that changes is that the central bank's previous target can no longer be used The central bank can still purchase and sell the corporate bonds as always.

While I can imagine New Keynesian economists insisting that the government run a budget deficit and issue some T-bills so that all of their models still work. I can imagine central bankers taking the same position so that they can get back to business as usual. But I can't imagine any economist thinking that monetary policy is ineffective.

Now, suppose the national debt isn't paid off, but private investors worry more about losses on corporate bonds. Those most worried sell the bonds and buy T-bills. The yield on T-bills is driven to zero. That is, the $1 billion of T-bills that are outstanding now have a zero yield. If people worried about the risk of corporate bonds still want more safety, there is no benefit to buying T-bills rather than just holding currency. Perhaps the demand for currency rises substantially.

Is monetary policy impossible? No, the central bank can continue to buy corporate bonds as usual. Presumably, the sale of corporate bonds and purchase of T-bills and accumulation of currency would tend to raise the yield on corporate bonds. The central bank can buy the corporate bonds, accommodate any increase in the demand for currency, and even reverse the increase in the yield on corporate bonds.

Of course, if there is a different story, where the supply of corporate bonds falls substantially, and the demand for them rises substantially as well, either directly by private investors or indirectly through a demand for currency. Then, perhaps, corporate bonds would reach the zero nominal bond.

But this account shows, much as Rowe was arguing, that monetary policy does not break down just because the shortest, safest, and most liquid security has a nominal yield of zero.

I suggest a third option: Fully privatize the issue of hand-to-hand currency.

Market Monetarists propose giving up using an interest rate policy instrument to target inflation and instead use adjustments in base money to target a growth path for nominal GDP.

It is possible that all the worries about secular stagnation will turn out to be the result of targeting inflation using a short and safe interest rate as an instrument.

However, it is certainly possible that the Market Monetarist approach will require a very large balance sheet for the central bank, with it creating short and safe monetary liabilities while holding longer and riskier assets.

The central bank could suffer losses on some of these risky assets. At the very least, this would reduce the profits paid over to the Treasury, and in the extreme, it could involve payments by the Treasury to bail out the central bank.

By privatizing hand-to-hand currency, the quantity of base money would be reduced. Private currency would not be base money. As for reserve deposits, if the demand for them rises so that the central bank has to expand its balance sheet "too much," then the central bank can reduce the interest rate it pays on them--even below zero.

In fact, I would suggest making central bank reserves into a mutual fund type instrument. The central bank should pay over to the banks holding the reserves the profits on its asset portfolio less a maintenance charge.

The result, of course, is that the nominal interest rates on short and safe assets, such as T-bills, can fall enough, perhaps below zero, to clear the market for them.

In my view, the reason for interest income is that investment can generate increased real output. However, real investment takes time and is uncertain. To generate a short and safe security, the risk must be shifted. Those saving should expect to pay if they want someone else to take part of the risk. The amount that must be paid for a zero duration and riskless security should be substantial. A negative nominal return, that is, paying someone to keep wealth "perfectly" safe, should not be shocking.

Further, the notion that hand-to-hand currency should be especially safe is an especially bad idea. Because it is extremely difficult to charge for providing that safety, it is better that the safest financial assets take the form of deposits, bonds, or bills. Their prices or yields can be adjusted, below zero if necessary, to clear the market.

Should the inflation rate be high enough at all times so that the market clearing nominal yield on all financial assets is positive at any time? I don't think so. I think the growth path of nominal GDP should be keep the price level stable on average. Generally, nominal values should reflect real values.

Should the government borrow enough so that everyone who wants to lend to the government can earn a good return? I don't think so. If the government can borrow at a very low interest rate, that does reduce the cost of capital projects, and so presumably there will be more such projects with positive net benefits. But the reason to fund those projects is not to generate higher real incomes for those funding the projects. Nor is the reason to fund the projects to provide more profit to contractors or higher wages to the workers.

Alex Salter shared a link to an earlier post. (Thanks.) Daniel Kuehn commented on facebook. I had claimed that a backwards looking Taylor rule is the mainstream of New Keynesian economics.

In other words, I claimed that Svennson's approach of targeting the forecast is not the mainstream. More importantly, Woodford's recent adoption of nominal GDP level targeting isn't close to being accepted by the mainstream of New Keynesian macroeconomists. Of course, if both of those positions became dominant among new Keynesian marcoeconomists, then the difference between the new Keynesian and Market Monetarist views would greatly shrink.

What would be the remaining difference? As I said before, the remaining difference would be the use of interest rates as a policy tool. New Keynesians emphasize that approach, Market Monetarists oppose it.

As an aside, I am very interested in monetary regimes that have no base money. Competing private banks issue banknotes and deposits that are convertible to index futures contracts on nominal GDP. I am not sure that this is workable. But with such a regime, there is neither a policy interest rate nor a quantity of base money. All market interest rates and quantities of monetary instruments would be entirely determined by market forces.

But, leaving aside such alternatives, like other Market Monetarists, I favor having the monetary authority adjust the quantity of base money to meet the demand to hold it while allowing market forces to determine all interest rates. Daniel Kuehn responded to this as well:

What is the difference between a Taylor rule and "the quantity of money should be adjusted according to the demand to hold money given a level target for nominal GDP"? You back out the Taylor rule's interest rate given a real output gap and an inflation rate, which is precisely the same idea.

I don't think a level target for nominal GDP is the same as an inflation target, even when adjusted for an output gap. A price level target adjusted for an output gap would be closer. And one of the benefits of nominal GDP level targeting is that there is no need to estimate an output gap. Perhaps Kuehn confuses nominal GDP level targeting with nominal GDP growth rate targeting. Targeting the growth rate for nominal GDP is closer to targeting inflation than is targeting the level of nominal GDP.

However, another point Kuehn appears to be making is that adjusting the quantity of base money to match the demand for base money given the target for nominal GDP is the same thing as adjusting the policy interest rate enough to keep nominal GDP on target.

Or, as Sumner suggests, the new Keynesian approach would be that the policy interest rate should be adjusted so that saving equals investment given the target level for nominal GDP. And as Sumner points out constantly, the difference is that the lower bound for the policy interest rate is approximately zero, while the upper bound on base money is the total amount of assets the central bank is allowed to purchase.

There are some possible scenarios where adjusting the quantity of base money to the demand to hold it will involve squeezing down the yield curve and risk differentials, and this could require the central bank to purchase long term and risky securities. The rule--expand the quantity of base money enough to meet the demand to hold it covers that possibility.

The rule, adjust the policy interest rate so that saving equals investment at a level of nominal GDP equal to target, requires substantial modification once that policy rate falls to slightly below zero. It must become keep the policy rate at zero for an extended period of time so that because long term rates depend on expected short term rates, long term rates will fall. And with lower safe rates, people will shift to riskier securities, lowering those rates too. A bit more complicated.

An alternative to this sort of forward guidance would be a shift in the policy rate. Rather than using a short and safe rate, as central banks like to do, a longer and riskier rate could be used. The open market trading desk could be instructed to get that BB corporate rate down to 4 percent. And then, they would buy up whatever assets they are allowed to buy until that rate falls to the target level. Of course, they might buy up everything they are permitted and still the rate is too high.

But this approach doesn't require that there be some commitment to keep the BB Corporate rate low for an extended period of time.

Finally, it is simply not the case that increases in base money must result in lower interest rates. While that is the ceteris paribus result, if others sell more securities than the central bank buys, and then use the funds to purchase consumer or capital goods, then an expansion in base money can be associated with rising interest rates and increased nominal expenditure on output. A commitment to keep interest rates low is a commitment to expand purchases of securities to offset these sales and keep interest rates from rising to clear credit markets.

What would be the analogy? A commitment to keep base money at some level (or growth path) until some particular future date. Market Monetarists do not favor such a commitment.

Thursday, January 9, 2014

Simon Wren-Lewis says that he is puzzled by the debate regarding monetary and fiscal policy.

In his view, "Macroeconomics" suggests that policy makers should be advised to use both fiscal and monetary policy at the zero nominal bound. While lowering the policy interest rate is superior to fiscal policy to increase demand, once the policy interest rate is at zero, all that is left is unconventional monetary policy or fiscal policy. "Macroeconomics" is uncertain regarding unconventional monetary policy. But Macroeconomics is certain about the effectiveness of fiscal policy. And so, both should be used.

The "policy makers" should use their discretion to build a mix of fiscal and unconventional monetary policy to expand demand.

My view is different.

I believe that the monetary authority should be given full responsibility for the nominal anchor and held accountable. Its job is to adjust the quantity of money to the demand to hold it subject to the constraint that spending on output remain on a stable growth path.

The monetary authority controls the quantity of base money and that is enough--unless the demand for base money is greater than the total quantity of assets it is legally permitted to buy. If the monetary authority buys up everything it can, and the interest rate on reserve balances is less than zero, and currency withdraws are occurring because it is cheaper to store currency than pay to keep money in banks, then fiscal policy might be the least bad option. We are not in that state now.

Why would fiscal policy help in that situation? Most obviously, budget deficits generate more assets for the monetary authority to buy. Another option that should be considered is expanding the assets the monetary authority can purchase. Or responding to currency withdrawals with a suspension.

The monetary authority has no control over taxes or government spending. It is inevitable that legislators will have divergent views about what taxes to cut and what kinds of spending to increase. Those that lose the political battle will complain about deficits and debt. From their perspective, cutting the wrong taxes or increasing the wrong spending is not worth the deficits and added debt.

In my view, "fiscal policy" is quite properly about the proper allocation of real output between the provision of private and public goods. That voters face a tax cost for public expenditures is a good thing. It helps them make a reasonable decision between the benefits of the public goods they hope to receive and the private goods they must sacrifice to pay taxes. In other words, "fiscal policy" should be about the composition of spending on output, not total demand.

What I favor regarding "fiscal policy" is lower taxes and less government spending. I favor cutting government spending more than taxes, generating a modest budget surplus and so a gradual paying down of the national debt. I don't favor such a policy as a means to raise nominal GDP. I don't think it would have much effect on nominal GDP.

But I do favor a Reagan/Volcker nominal recovery and then slow steady growth of spending on output afterwards. How can that be accomplished? By having the monetary authority target a growth path for nominal GDP.

Obviously, promoting temporary increases in government spending does nothing to promote my preferred fiscal policy. I don't see temporary tax cuts as much better.

But I also think that suggesting fiscal policy makes desirable monetary reform less likely. It provides an out for central bankers who want to continue with business as usual.

The Fed and other central banks have always preferred to manipulate short term interest rates. The notion that the legislature needs to change fiscal policy enough so that a central bank can keep policy interest rates in a range they find comfortable is encouraging central bank malpractice

Still further, inflation targeting has proven to be a mistake. Recoveries from demand short falls have been very slow since inflation targeting gained favor. While a slow recovery from a mild recession is not a good thing, the slow recovery from the deep recession of 2008 to 2009 has been a disaster.

I see Wren-Lewis as sharing the view of the central bankers. Continue with business as usual as much as possible. If it fails, it is the economy's fault. Let the legislature increase spending or cut taxes enough so that central bankers can stay within their comfort zones.

I was also troubled by Wren-Lewis' statement that both monetary policy and fiscal policy work in a similar fashion--to expand demand by shifting expenditures from the future to the present. I think he takes new Keynesian models much too seriously.

My view is that a good monetary regime adjusts the quantity of money to the demand to hold money. This avoids the disruption caused by monetary disequilibrium and is necessary to maintain the nominal anchor. Adjusting the quantity of money to the demand to hold it has no necessary implications for shifting spending on output from future to present.

However, monetary policy is also the lever that maintains the nominal anchor. If the economy breaks away from its nominal anchor, the monetary regime must generate monetary disequilibrium to bring it back to its moorings. That also has no implication for shifting spending from future to present.

Why does Wren-Lewis make this statement? Because he is identifying monetary policy with changes in a policy interest rate. He is most certainly reasoning from a price change. A lower interest rate reduces saving and increases consumption now. But the reduced saving implies less consumption in the future. There is a shift in consumption from the future to the present. The way monetary policy increases demand is by lowering the policy interest rate so that consumption rises now, which implies it falls in the future.

My view is that interest rates coordinate saving and investment. If there is an increase in the supply of saving, that implies a plan to decrease consumption now and increase it in the future. The reduction in the interest rate tends to decrease the quantity of saving supplied, which implies more consumption now. However, there is also an increase in the quantity of investment demanded. In the new equilibrium, there is reduction in current consumption and an increase in current investment.

I don't see this as a shift in spending from the future to the present. The change in the quantity of saving supplied in response to the lower interest rate is just one part of the process. And even if investment demand were perfectly inelastic, the "purpose" of the lower interest rate isn't to move consumption from the future to the present, but rather to maintain current consumption. But better yet, the "purpose" of the lower interest rate is to coordinate the decisions of individual savers so that total saving equals the amount invested.

Suppose there is a decrease in investment demand. The lower interest rate decreases the quantity of saving supplied which implies a shift of consumption from the future to the present. There is also an increase in the quantity of investment demanded. In the new equilibrium, there is less saving, more consumption, and less investment. This comes much closer to what Wren-Lewis suggested. But this isn't due to monetary policy, but rather due to the decrease in investment demand.

Put those two shifts together. The supply of saving rises and the demand for investment falls. The interest rate falls enough so that the quantity of saving supplied and quantity of investment demanded are again equal. The amount saved and invested could stay the same, increase, or decrease. Was the purpose of a lower interest rate to shift consumption to the present from the future? No, it was to coordinate saving and investment with no particular implication about consumption now and in the future.

In my view, it is certainly possible for a central bank to shift the quantity of money to manipulate interest rates. And even if a central bank holds the quantity of money constant, it is very possible for changes in interest rates to impact the demand to hold money. The resulting monetary disequilibrium can easily interfere with the market adjustment in interest rates needed to coordinate saving and investment.

For example, suppose the supply of saving increases, the demand for investment decreases, and the demand to hold money rises. The central bank raises the quantity of money just enough to prevent any liquidity effect that would raise interest rates. At the market interest rate, saving is more than investment. The amount invested falls as does consumption spending.

Now, let's suppose that the central bank expands the quantity of base money enough to meet the demand for money, allowing market interest rates to fall to a level so investment and saving are again equal. Investment and consumption spending both rise. Was the purpose of relieving the monetary disequilibrium to shift consumption from the future to the present? No, the result might be a shift of consumption from the present to the future or no shift at all. The point was to relieve the monetary disequilibrium and allow the market interest rate to adjust enough to coordinate saving and investment.

Finally, suppose the reason that saving increased and investment decreased is because spending on output has fallen to a lower growth path. Money wages are much too high, and while the growth of wages has slowed, and should eventually converge with the new equilibrium growth path for wages, the process is slow. Real output and employment are depressed.

If the central bank commits to getting nominal GDP back to the previous growth path, saving will fall and investment will rise. The interest rate needed to coordinate saving and investment will rise. Is the purpose of this commitment to raise nominal GDP to shift spending from the future to the present. No. The propose is to increase spending in the future and the present.

Monday, January 6, 2014

Scott Sumner asked how Market Monetarism is different from the new Keynesian economics.

There is a lot of difference between Market Monetarism and the new Keynesian mainstream of a backward-looking Taylor rule.

Those new Keynesians who favor adjusting policy interest rates to target the forecast for the growth path of nominal GDP as a policy regime are not the mainstream. But certainly they still count as new Keynesians.

We do not favor having the central bank "set" any interest rate or especially to make commitments as to what those interest rates will be in the future.

For example, Market Monetarists do not favor keeping the Federal Funds rate near zero for an extended period of time, one or two years, or even until unemployment falls below 6.5% or inflation rises above 2.5% in the medium run.

Market Monetarists especially don't favor quantitative easing as a means to lower long term interest rates.

The theoretical framework of Market Monetarism is that spending on output depends on the quantity of money and the demand to hold it. And the quantity of money should be adjusted according to the demand to hold money given a level target for nominal GDP.

Sumner did discuss the new Keynesian focus on interest rates, but is it really true that new Keynesians focus on the difference between a policy rate and the Wicksellian natural rate?

As for the difference Sumner emphasizes, the use of "the market" as an indicator of monetary policy, I think that is less essential. I have a longstanding interest in index futures convertibility, but I have never believed that it is practical to use stock prices or commodity prices to judge the proper level of base money.

Saturday, January 4, 2014

Scott Sumner's first post on Econlog was about the "test" of Market Monetarism. Market Monetarists have generally taken the view that monetary policy, broadly understood, is able to keep spending on output on a target growth path regardless of fiscal policy. In particular, fiscal austerity can be offset.

Sumner had already commented on Paul Krugman and Mike Konczal's prediction that the fiscal austerity in 2013 would throw the economy into recession along with their statement that it would provide a test of the Market Monetarist claim that the Fed can offset the effect of such a contractionary fiscal policy. Sumner has generally been of the view that the Fed would in fact provide a monetary offset.

My own view is that the Fed could do so, though what it would do was more uncertain. Until the Fed targets a growth path of nominal GDP, I don't see that there has been a test of Market Monetarism.

Sumner claims that Market Monetarism passed the test with flying colors. He says that nominal GDP growth was about the same in 2013 as 2012.

NGDP grew by 3.8% between 2011:4 and 2012:4, and is growing by 4.0% so far during 2013 (the fourth quarter is also expected to be strong.) That's not much better than 2012, but market monetarism wins even if the two numbers are about equal.

Konczal linked to the following graph:

Bob Murphy commented on the debate and implies that it certainly looks like nominal GDP growth is especially low during 2013. The data presented here is growth from one year before. The data is quarterly, but only the year is on the horizontal axis.

Admittedly, Sumner often follows the modern economic convention of focusing on growth rates. In my view, the last five years has shown that a narrow focus on growth rates is a mistake. Instead, it is important to look at levels.

Let's return to the typical Market Monetarist diagram:

Nominal GDP remained on a remarkably stable growth path during the Great Moderation. The recession that began at the end of 2007 was nothing unusual, but then there was a substantial drop in nominal GDP, and rather than return to its previous trend, it seems to have shifted to a substantially lower growth path that has a slightly lower growth rate. Focusing on the slightly lower growth rate ignores the real problem--the lower level of nominal GDP.

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The following diagram focuses on the Great Recession and snail-paced recovery.

All of the focus on growth rates is really just the minimal fluctuations around this new trend. The growth rate is 4 percent rather than the 5.4 percent of the Great Moderation. (Sumner's 5 percent target adds the trend growth rate of potential output during the Great Moderation, 3 percent, with the 2 percent inflation target favored by modern central banks. The actual trend was slightly more than 5 percent.)

Here is a close-up of the variation of nominal GDP from its new trend:

The largest deviations from this trend are .6 percent of nominal GDP. During the third quarter of 2012, nominal GDP was .6 percent above trend. By the second quarter of 2013, it was .6 below trend--a slightly more than 1 percent change. And by the third quarter of 2013, it was almost at trend (.1 percent below.)

Looking at Market Monetarist diagrams, it looks like fiscal austerity has a small (approximately 1 percent) negative impact on spending that lasted less than a year.

In truth, I wouldn't expect much better if the Federal Reserve were explicitly targeting nominal GDP one year in the future. But perhaps I should.

The problem is that the Fed's discretionary forward guidance with reference to the unemployment rate and inflation is not generating an adequate nominal recovery. I think the economy needs a Reagan/Volcker recovery. A year of 10 percent nominal growth. And one year from now, that should be the start of a new target growth path. While I would prefer 3 percent, the current 4 percent growth rate wouldn't be too bad. In my view, it would be better than 5 percent much less the 5.4 percent of the Great Moderation.

Friday, January 3, 2014

In the previous post, I contrasted the use of gold coins and a very simple version of "shadow banking." Holding and trading T-bills as a money substitute provided both private and social benefits. A breakdown in the ability to trade T-bills would lead to potentially severe macroeconomic disruption too. On the other hand, with a fiat currency, trading T-bills as a money substitute still provided private benefits, but no social benefits. Further, some disruption in trading T-bills so that the private benefits disappeared would not create macroeconomic disruption--all that is necessary is open market purchases of the T-bills.

Suppose instead of using bags of gold or bundles of fiat currency notes, money mostly takes the form of bank deposits. Payments are made by writing checks or the electronic equivalent. Banks accept payments at par and settle up net clearing balances. Competitive banks pay interest on deposits and fund a variety of assets, including T-bills.

Now, let's suppose that some financial and other firms begin to hold T-bills and trade them as a money substitute. A buyer first sells T-bills. The proceeds are credited to the buyer's transactions account at a bank. The buyer then makes a purchase from a seller. The funds are transferred to the sellers account. If the seller also uses T-bills as a money substitute, the seller purchases T-bills. The funds are then removed from the seller's account. Obviously, this purchase requires double the transactions. The buyer had to sell T-bills to fund the purchase and the seller purchased T-bills with the receipts from the sale. These transactions represent social costs, but there is no reason to expect that these social costs deviate much from the private costs faced by the buyer and seller.

What is the private benefit? By holding T-bills rather than deposits, those using T-bills as a money substitute gain the difference between the interest rate banks pay on transactions accounts and the yield on T-bills. Of course, that benefit is directly a private loss to the banks, and so the social benefit is really the banks' cost of intermediation.

Since banks use deposits to fund a variety assets, the use of T-bills as a money substitute would tend to reduce the yield on them. Of course, those who would otherwise borrow from banks would need to obtain funding elsewhere. Some of those who were holding T-bills might purchase other assets. The government might even adjust its funding to take advantage of the lower yields on T-bills.

Since banks can (and do) secure deposits with government bonds, risk is not an issue. To the degree that the added transactions cost of using T-bills as a money substitute are less than what it costs banks to intermediate T-bills, the use of T-bills as money substitutes would appear efficient. Still, any social gain is likely minimal. And, of course, it is possible that the cost of intermediating T-bills is so low that there is a net social loss.

Why would T-bills be used as a money substitute even if it were inefficient? Suppose the banks form a cartel, and agree to stop paying interest on transactions accounts. To control cheating on the agreement, they convince government to enforce the regulation. They come up with some plausible rationale--competition for deposits leads to excessively risky asset portfolios.

With this price control, the private benefit to using T-bills as money substitutes is similar to the scenario where money is a bag of gold coins or packets of currency. Of course, this private benefit is at the expense of the rents that the banks would have made. Small depositors find managing their money balances too costly, and so earn no interest and banks earn rents at their expense. Large depositors use T-bills as money substitutes to reduce their deposit balances. The added transactions costs of trading the T-bills is a way to reduce the private burden of an undesirable regulation.

Those who would have held the government debt that is now being used as money substitutes instead use their funds in other ways. Similarly, those that would have borrowed from the banks must fund their operations in other ways. The first pass assumption should be that this makes the financial system less efficient. Too much other finance, and too little activity financed by banks. Of course, if banks just held T-bills, then there is no such loss. The banks would hold fewer T-bills and those using them as a money substitute would hold more.

Now, through some truly odd turns of events, suppose that the government repeals the regulation on deposit interest rates solely for households. Thankfully, households are no longer exploited, but still, firms are motivated to minimize their transactions balances and instead use money substitutes. They don't earn interest on their deposits. Perhaps this is some kind of rent-seeking equilibrium, but it is hard to see how it is efficient. Why not just have the banks hold the T-bills (and perhaps other assets) and pay competitive interest to the firms? Well, there would be less business for the bond dealers making markets in the securities and the firms' own money market traders would need to find new work.

Suppose that a loss of trust in those trading the T-bills develops, and so firms switch to holding deposits. This is a private calamity for those trading T-bills, including the firms' own money managers. But the social problem is easily solved. The banks just buy the T-bills that would have been held by the firms.

Finally, suppose interest rates on T-bills fall. This makes the benefit of trading T-bills as a money substitute smaller. The price ceiling on business deposits becomes less relevant. Presumably, the result would be for firms to hold deposits in banks instead of T-bills. Again, the simple solution is for the banks to purchase the T-bills.

Of course, this remains a private calamity for those trading the T-bills. All of those extra transactions in T-bills generated income for them. And those who traditionally worked so hard to manage their firms' cash positions now have nothing to do. But, of course, much of their activity was inefficient waste all along.

Now, let's suppose that our money market traders respond to lower T-bill yields by trading commercial paper backed by securities backed by mortgages. Sure, trading low yield T-bills as a money substitute might not be worth the extra transactions costs, but the need for "safe" collateral leads to a series of complicated financial transactions where banks make mortgages, sell them to investment banks who securitize them, and then fund portfolios of them by selling asset backed commercial paper. This asset backed commercial paper can now be used as a money substitute.

Rather than sell them and then make a purchase, it is possible to borrow against them, and then make a purchase. By organizing this as a repurchase agreement, the lender avoids complications in a bankruptcy.

Anyway, it turns out that many of the mortgages were only sound if housing prices continued to rise, and some of the senior mortgage backed securities also required rising housing prices to be low risk. Those investment banks who were issuing asset backed commercial paper no longer could find lenders. They had been borrowing new money to pay off claims as they came due, but that became impossible.

And so rather than a shift out of T-bills to deposits as before, the shift is out of more exotic money market instruments into T-bills. And as the yields on T-bills were driven down for many reasons, a shift from T-bills to more standard bank deposits.

Of course, my emphasis so far was on how trading money market instruments as a money substitute involves wasteful transactions costs. But what about what the asset backed commercial paper was funding? How can mortgages be funded? Well, the banks originating the mortgages can hold them. The firms that hold funds in checkable deposits rather than hold asset-backed commercial paper as a money substitute provide the banks with a source of funds for mortgages.

Yes, this is a private calamity for all of those who were involved in creating a shadow banking system all aimed at providing slightly higher yields to motivate firms to manage cash balances rather than just leave funds in their checking accounts. Unfortunately, that shift, from banks selling mortgages to holding them as checkable deposits is not quite as simple as purchasing T-bills. Mortgages are risky, and banks need capital as well as deposits.

Still, the private interests of those who are involved in the shadow banking industry should not be confused with economic efficiency.